Apple (AAPL) is increasingly dominating the Smartphone market as they systematically extend their footprint to new carriers, new products and new geographies. This footprint expansion will certainly have a knock-on effect for their suppliers. Anticipating which supplier's revenue and profit may skyrocket is a game many play - herein I make a bullish case for one of those suppliers.
The impact of the Siri personal assistant on the iPhone 4S has been nothing short of astounding. Upon the release of the 4S, the supposed cognoscenti pronounced it inadequate for many reasons including the lack of a larger screen and not having the 4G LTE speeds of Android (GOOG) partners HTC and Samsung. What then happened is that customers fell in love with the brilliant interface of the latest iPhone but most of all they loved Siri. This feature along with the pent up holiday season demand created the single most amazing quarter in terms of NI growth (118%) on such a large scale ($13BB) in the history of stock equities.
With this as the backdrop, consider Nuance (NUAN), a preeminent company in the playground of intelligent voice response and transcribing, which supplies the brains of the Siri intelligent voice response. As of this writing, Nuance sells for 26 after a 20% drop, post February 9th earnings. As one reads through the earnings call transcript it becomes clear the reason for the shortfall in meeting expectations was the "larger, more comprehensive and complex contractual agreements" per CEO Paul Ricci. This complexity will be favorable long term for Nuance as it typically leads to greater customer stickiness. The near term downside is that these contracts utilize service level agreements (SLAs) with milestones which create revenue and royalty deferrals. The issue is compounded for Nuance; they are not recognizing revenue but are recognizing the associated costs. It is encouraging that even with this accounting anomaly, their YOY Income growth increased from break even to $9MM.
A list of the tailwinds expected to drive iPhone 4S sales much higher and by proxy Nuance Revenues and stock price:
- China Impact: The iPhone 4S will now be sold in China for a full quarter via China Unicom (CHU). Additionally it was reported Monday that Apple added China Telecom (CHA) as a new carrier. Combined they have a 3G customer base of 82MM. See Bloomberg article. Using a conservative 15% penetration yields 12MM new customers for Nuance software to be installed on.
- iPad3: the March launch is projected to incorporate Siri.
- iTV: Expected to launch later this year and projected to use Siri. As a side note, the Nuance Dragon TV platform was recently announced to be incorporated into the new Panasonic digital TV.
- PC replacement: The accuracy of transcribing voice to text is achieved an inflection point that promotes email and document creation due to its speed and accuracy. This new approach will sidestep the "typing issue" some attribute to flat screen tablets. If you've used this technology to send texts, you quickly recognize the power of this amazing speed and accuracy.
- Acquisition: There is the outside chance that Apple will invest some of their $100BB cash hoard to purchase Nuance and become more vertically integrated to control more elements of their product and process. The probability of this is low but the $8BB purchase is within reach of Apple's US cash. Is there a company better positioned than Nuance to get scooped up?
- Stock buyback: Nuance stock buybacks that have been mentioned by Analysts covering Nuance.
- Revenue catch-up as per above earnings call transcript.
To be balanced, there are concerns to consider before buying into the Nuance thesis as follows:
- The stock has higher than average risk (beta = 1.5).
- The stock has already run up 34% in the past 12 months.
- Multiple insiders' sells (automatic?) occurred February 15th after earnings were reported.
- Apple has a history of finding the low cost, high quality suppliers and leaving the others behind. This may already be occurring, we do not know. We do know for sure Nuance has recently gobbled up their main competitors (SWYPE, VLINGO) in an effort to prevent this from occurring.
In conclusion, Nuance stock price movements should be more strongly correlating with that of Apple's stock price movements. They are not correlated recently due to the overreaction to revenue deferrals. This market reaction I suspect will be reversed in future quarters.